It’s not clear to me whether Mr. Trump’s macroeconomic policy forms a coherent whole (so far it doesn’t seem to). I’m not sure either whether, or how well, he understands the implications of the steps he’s taking.

The major thrusts:

income taxes

Late last year, the Trump administration passed an income tax bill. It had three main parts:

–reduction in the top corporate tax rate from 35% (highest in the world) to 21% (about average). This should have two beneficial effects: it will stop tax inversions, the process of reincorporating in a foreign low-tax country by cash-rich firms; and it removes the rationale for transferring US-owned intellectual property to the same tax-shelter destinations so that royalties will also be lightly taxed.

–large tax cuts for the wealthiest US earners, continuing the tradition of “trickle down” economics (which posits that this advantage will somehow be transmitted to everyone else)

–failure to eliminate special interest tax breaks, or adopting any other means for offsetting revenue lost to the IRS from the first two items.

Because of this last, the tax bill is projected to add $1 trillion + to the national debt over time. Also, since the reductions aren’t offset by additional taxes elsewhere, the tax cuts represent a substantial net stimulus to the US economy.

This might have been very useful in 2009, when the US was in dire need of stimulus. Today, however, with the economy at full employment and expanding at or above its long-term potential, the extra boost to the economy is potentially a bad thing, It ups the chances of overheating. We need only look back to the terrible experience of runaway inflation the late 1979s to see the danger–something which would require a sharp increase in interest rates to curtail.

interest rates

Arguably, the new income tax regime gives the Fed extra confidence to continue to raise interest rates back up to out-of-intensive-care levels. More than that, the tax cut bill seems to me to demand that the Fed continue to raise rates. Oddly–and worryingly, Mr. Trump has begun to jawbone the Fed not to do so. That’s even though the current Fed Funds rate is still about 100 basis points below neutral, and maybe 150 bp below what would be appropriate for an economy as strong as this. Again this raises the specter of the political climate of the 1970s, when over-easy money policy was used for short-term political advantage …and of the 20%+ interest rates needed in the early 1980s to undo fiscal and monetary policy mistakes.

trade

This is a real head-scratcher.

“national security”

The Constitution gives Congress control over trade, not the executive branch of government. One exception–Congress has delegated its power to the president to act in emergency cases where national security is threatened. Mr. Trump argues (speciously, in my view) that there can be no national security if the economy is weak. Therefore, every trade action is a case of national security. In other words, this emergency power gives the president complete control over all trade matters. What’s odd about this state of affairs is that so far Congress hasn’t complained.

I’m taking off my hat as an American and putting on my hat as an investor for this post.

That is, I’m putting aside questions like whether the Trump agenda forms a coherent whole, whether Mr. Trump understands much/any of what he’s doing, whether Trump is implementing policies whispered in his ear by backers in the shadows–and why congressmen of both parties have been little more than rubber stamps for his proposals.

My main concern is the effect of his economic policies on stocks.

the tax cut

The top corporate tax rate was reduced from 35% to 21% late last year. In addition, the wealthiest individuals received tax breaks, a continuation of the “trickle down” economics that has been the mainstay of Washington tax policy since the 1980s.

The new 21% rate is about average for the rest of the world. This suggests that US corporations will no longer see much advantage in reincorporating abroad in low-tax jurisdictions. The evidence so far is that they are also dismantling the elaborate tax avoidance schemes they have created by holding their intellectual property, and recognizing most of their profits, in foreign low-tax jurisdictions. (An aside: this should have a positive effect on the trade deficit since we are now recognizing the value of American IP as part of the cost of goods made by American companies overseas (think: smartphones.)

My view is that this development was fully discounted in share prices last year.

The original idea was that tax reform would also encompass tax simplification–the elimination of at least part of the rats nest of special interest tax breaks that plagues the federal tax code. It’s conceivable that Mr. Trump could have used his enormous power over the majority Republican Party to achieve this laudable goal. But he seems to have made no effort to do so.

Two important consequences of this last:

–the tax cut is a beg reduction in government income, meaning that it is a strong stimulus to economic activity. That would have been extremely useful, say, nine years ago, but at full employment and above-trend growth, it puts the US at risk of overheating.

–who pays for this? The bill’s proponents claim that the tax cut will pay for itself through higher growth. The more likely outcome as things stand now, I think, is that Millennials will inherit a country with a least a trillion dollars more in sovereign debt than would otherwise be the case.

One positive consequence of the untimely fiscal stimulus is that it makes room for the Fed to remove its monetary stimulus (it now has rates at least 100 basis points lower than they should be) faster, and with greater confidence that will do no harm.

Two complications: Mr. Trump has begun to jawbone the Fed not to do this, apparently thinking a supercharged, unstable economy will be to his advantage. Also, higher rates raise the cost of borrowing to fund a higher government budget deficit + burgeoning government debt.

It looks as if the top Federal corporate tax rate will be declining from the current world-high 35% to a more median-ish 20% or so. The consensus guess, which I think is as good as any, is that this change will mean about a 15% one-time increase in profits reported by S&P 500 stocks next year.

However, Wall Street has held the strong belief for a long time that this would happen in a Trump administration. Arguably (and this is my opinion, too), one big reason for the strength in US publicly traded stocks this year has been that the benefits of corporate tax reform are being steadily, and increasingly, factored into stock quotes. The action of computers reading news reports about passage is likely, I think, to be the last gasp of tax news bolstering stocks. And even that bump is likely to be relatively mild.

In fact, one effect of the increased economic stimulus that may come from lower domestic corporate taxes is that the Federal Reserve will feel freer to lean against this strength by moving interest rates up from the current emergency-room lows more quickly than the consensus expects. Although weening the economy from the addiction to very low-cost borrowing is an unambiguous long-term positive, the increasing attractiveness of fixed income will serve as a brake on nearer-term enthusiasm for stocks.

What I do find very bullish for stocks, though, is the surprising strength of consumer spending, both online and in physical stores, this holiday season. We are now nine years past the worst of the recession, which saw deeply frightening and scarring events–bank failures, massive layoffs, the collapse of world trade. It seems to me that the consumer spending we are now seeing in the US means that, after almost a decade, people are seeing recession in the rear view mirror for the first time. I think this has very positive implications for the Consumer discretionary sector–and retail in particular–in 2018.

The general outline of the Trump administration’s proposed revision of the corporate and individual income tax systems was announced yesterday.

The possible elimination of the deductability from federally taxable income of individuals’ state and local tax payments could have profound–and not highly predictable–long-term economic effects. But from a right-now stock market point of view, I think the most important items are corporate:

–lowering the top tax bracket from 35% to 20% and

–decreasing the tax on repatriated foreign cash.

the tax rate

My appallingly simple back-of-the-envelope (but not necessarily incorrect) calculation says the first could boost the US profits of publicly listed companies by almost 25%. Figuring that domestic operations account for half of reported S&P 500 profits, that would mean an immediate contraction of the PE on S&P 500 earnings of 12% or so.

I think this has been baked in the stock market cake for a long time. If I’m correct, passage of this provision into law won’t make stock prices go up by much. Failure to do so will make them go down–maybe by a lot.

repatriation

I wrote about this a while ago. I think the post is still relevant, so read it if you have time. The basic idea is that the government tried this about a decade ago. Although $300 billion or so was repatriated back then, there was no noticeable increase in overall domestic corporate investment. Companies used domestically available cash already earmarked for capex for other purposes and spent the repatriated dollars on capex instead.

This was, but shouldn’t have been, a shock to Washington. Really, …if you had a choice between building a plant in a country that took away $.10 in tax for every dollar in pre-tax profit you made vs. in a country that took $.35 away, which would you choose? (The listed company answer: the place where favorable tax treatment makes your return on investment 38% higher.) Privately held firms act differently, but that’s a whole other story.

The combination of repatriation + a lower corporate tax rate could have two positive economic and stock market effects. Companies should be much more willing to put this idle cash to work into domestic capital investment. There could also be a wave of merger and acquisition activity financed by this returning money.

The rate at which the domestic earnings of US corporations are taxed by the federal government is unusually high by world standards.

Corporate response has been what one would expect: some firms leave for lower-tax jurisdictions; others engage in elaborate tax avoidance schemes, the bare bones of which I wrote about yesterday; still others spend tons of time and money lobbying Congress for exemptions. Not a pretty picture.

What to do?

The straightforward answer would be to lower the tax rate and eliminate the special treatment. Of course, congressmen, lobbyists and the industries receiving tax breaks are all against the latter.

border tax

That’s one reason for the appeal of a flat tax of perhaps 20% on the value of all imports–it leaves the status quo untouched but raises tax dollars to offset those lost through reducing rates.

A border tax would have another advantage, eliminating abuses from transfer pricing. This is a practice whereby goods imported into the US are first shunted on paper through a tax haven where their price is raised. The effect is to redirect profits from the US to the tax shelter country.

problems

The biggest theoretical issue with a border tax is the law of comparative advantage, the idea on which most international commerce is based that countries all gain by specializing in what they do best and buying everything else from abroad. Contrary to what one might think at first, trying to do everything in-country and taxing imports reduces national wealth.

A big practical defect of the border tax, to my mind, is that there are mammoth categories of everyday goods–food, clothing, furniture, toys–that are only available at low cost in the US because they are made abroad. Another is the question of retaliation, as the US is now doing against Canadian efforts to favor local milk products over imports from Wisconsin.

a rising dollar?

Border taxers reply to the higher-cost-of-imports issue by claiming that implementing a border tax will cause the dollar to rise–maybe even by enough to offset the effects of the border tax in dollar terms. How so?

The argument is that every day US parties go into the currency markets wanting to exchange dollars for foreign currency. Similarly, foreigners come with their currency to exchange into dollars to buy US-made stuff. The interaction of supply and demand sets the exchange rate.

Post border tax, higher prices of foreign goods means less demand in the US for them, which means fewer dollars available for exchange, which means the price of dollars goes up. Some border tax advocates claim the dollar spike could be as much as +25%-30%.

huh?

I suppose this line of reasoning could be right. But it seems to assume, among othe things, that, contrary to what we’re doing with Canada, no one retaliates; and that demand for now-higher-priced US goods remains relatively unaffected. Good luck with that.

Ultimately, though, I think that, whatever the strength of its conceptual underpinnings, the border tax is an attempt to avoid attacking the rats nest of special interest exemptions in the tax code while still lowering the headline rate. So it’s “fixing” one tax distortion by creating another. That’s vintage Washington. But making taxes more complex, not less, is a recipe for trouble.

President Trump has submitted the outline of his income tax plan, reportedly in bullet points on a single sheet of paper, to Congress. Although some have derided the lack of detail provided, the submission at least makes it very clear what is going on–and will likely help underscore the allegiance to special interests that opponents to what I considr a no-brainer tax fix may be serving.

On the corporate side, the reduction of the top rate to 15% will address three very important tax issues, all spawned by the fact that US corporate income tax (for those unable to cut a sweetheart deal) is higher than just about any other place on earth. The current problem areas I see them are three:

—inversions, where a company paying full freight in the US reincorporates on paper, usually through a merger with a foreign firm, in a low-tax country like Ireland (where the tax rate is in the low teens). Pharmaceutical companies, which have few ways of reducing their taxable income, have been the most prominent group doing this. At the stroke of a pen, their after-tax income goes up by 30%.

—transfer pricing, a long-time standby of multinationals. That’s where goods made by a third party in, say, China and destined for ultimate sale in the US are bought for, say, $10 each by the on-paper subsidiary of a US firm. The goods are marked up by Hong Kong to $20 and sold for that to the US parent. Since foreign firms doing business in Hong Kong pay no corporate tax, that $10 markup, which probably remains in a bank in Hong Kong, allows the parent to avoid paying $3.50 or so in tax to the IRS.

—intellectual property transfer, a variation on transfer pricing. A US firm transfers its patents, ownership of its brand name… to a subsidiary in a low-tax jurisdiction. Ireland is a favorite destination. It pays royalties to the subsidiary for the use of the intellectual property, generating an expense that reduces US income otherwise taxed at 35%, while paying less than half that to the country where the intellectual property is now domiciled.

One major effect of these strategies is that all of the cash saved is trapped abroad. This is because IRS regulations require corporations repatriating such foreign income to pay tax on the transfers equal to the difference between the US and foreign tax rates. That’s the reason multinationals are constantly lobbying Congress to declare a tax holiday for repatriations like these.

It will be interesting to see what happens.

Note: the one virtue of what I consider the otherwise loony border tax is that it would remove the appeal of the extensive network of transfer pricing/IP transfer schemes already in place. More about this tomorrow.

I think corporate tax reform is potentially the most significant item on the Trump administration agenda, as far as US stocks are concerned.

The Trump plan appears to have two parts:

–reduce the top corporate tax rate from 35% to, say, 20%. For a firm that has 100% of its income in the US and which has no substantial current tax breaks, reducing the corporate tax rate would mean a one-time 23% increase in after-tax profit.

–eliminate foreign tax reduction devices. American multinationals, facing high domestic corporate taxation, have resorted to two general types of tax avoidance devices. They have: (1) transferred intellectual property (brand names, patents…) to low-tax foreign jurisdictions like Ireland, and (2) located distribution subsidiaries in similar places. Hong Kong, where the income tax on profits generated by foreign companies is zero, is a favorite.

How this structure works: a US-based multinational uses a Hong Kong subsidiary to pay a contract manufacturer in China $150 for a mobile telecom device. The Hong Kong subsidiary sells the device to its US marketing subsidiary for $250. The US company pays the Irish subsidiary a $100 royalty for the use of the firm’s proprietary technology and brand name. It sells the device to a US customer for $600, recognizing, say, a $200 pre-tax profit in the US, and paying $70 in federal income tax. Without Hong Kong and Dublin, the firm would have a pre-tax profit of $400 and pay $140 in tax.

If I understand correctly, President Trump’s intention is to tax this hypothetical multinational on the entire $400 of pre-tax earnings on sales made in the US–no longer allowing cash flow to be syphoned off to foreign tax havens. At a 20% rate, the firm would pay $80 in federal income tax.

The bottom line: while tax reform of the type I think Mr. Trump has in mind might leave large multinationals no worse off than they are today, it would be a significant benefit to small and medium-sized firms, which tend not to have elaborate tax departments and to be much more US-focused. Just as important, it would eliminate the motivation to create offshore profit centers.

As/when the timing of corporate tax reform becomes clearer, I’d expect further rotation on Wall Street away from multinationals and toward domestic-oriented stocks. A quick-and-dirty way of locating beneficiaries–look for corporate tax rates at or near 35%.